Thursday, June 09, 2016

The risks of low and negative interest rates in the Eurozone

From around 4% in 2008, the ECB has been lowering its benchmark interest rate to a record low
0.0% today. In June 2014, it cut the interest rate on its deposit facility to
-10 basis points (bps), a big change from 2008 when the rate was 325 bps. Most
recently, the central bank cut its deposit rate further into negative territory
to a fresh new low of -40 basis points with effect from March 16, 2016.

It should be stressed that this short term
rate setting by the ECB is only oneof the factors leading to long term rates going
steadily lower in recent years, apart from increased international saving and the expansionist monetary policies of other leading central banks. A contrarian
could perhaps even describe low rates as a sign of economic health, pointing out how in the fifteenth century in Europe,
interest rates fell from 14 per cent to 5 per cent. They even hit 3 per cent in
the Netherlands in the sixteenth century, then at the lowest level in Europe.
The jury is still out to what extent today’s low rate environment is
“artificial”, as a result of central bank activism, or “natural”, as a result
of increased saving due to increased wealth.

In any case, ECB President Mario Draghi has
always defended this "accommodative”
monetary policy” as a means to “support prospects of an economic recovery”, as
he said for example back in 2013. Whether this target has been reached is a
matter for debate, which isn’t so easy to settle, given that we can’t be sure
what would have happened otherwise. What is certain, however, is that low
interest rates do have material consequences. Hereunder we’ll provide an
overview of these:

Especially in the North of the Eurozone, there has been a lot of
discontent over the relentless decrease in return savers enjoy from their deposit accounts. Several
German institutes have come up with estimates of the cost. According to DZ
Bank, after six years of low rates, the average German citizen would have lost out on €2,450 by the end of 2016. Germany’s prominent IFO
institute also took into account the damage low interest rates have wrecked
upon life insurances and voluntary private pensions, claiming that combined
with the losses for deposit accounts, the cost for Germany alone would amount to €327bn euro since 2008.

These calculations may overlook that one can’t just assume that
interest rates would have stayed at a higher level, given the disruption of the
financial crisis in 2008. Some would even contend that one can’t assume the
mere survival of many banks in the absence of extraordinary central bank
measures, which include lowering short term interest rates.

In the Netherlands, where pension funds manage not less than 1 trillion euro, they were forcedto cut payouts already and may need to do so again.
This led to the pension industry sounding the alarm, calling the situation “dramatic”. The Dutch Central Bank President was even convoked to Parliament for an explanation. Those
trying to counter the criticism have arguedthat the payout cuts were due to the Dutch regulations requiring pension
funds to have a cushion. Disagreements persist whether these regulations are
too stringent and even if so, whether they should be lowered just to alleviate
the effects of lower interest rates.

Also Germany’s very large insurance industry, which was forced to reduce benefits for clients, has complained. This, along with the criticism of German savings banks, contributed to sharp political attacks from
senior German policy makers. Bavaria’s Finance Minister Markus Soeder dubbed the ECB’s interest rate policies “gradual
expropriation” of savers and insurers. Also German Finance Minister Schäuble
and deputy Chancellor Sigmar Gabriel, a social democrat, have blamed the ECB.

Mario Draghi has responded the ECB isn’t really responsible for low
rates, claiming these really are a consequence of a “global excess of savings”
and are “a symptom of low growth and low inflation”.

This indeed goes to the heart of the debate:
to what extent is the ECB, which can only set short term rates, also
responsible for long term rates? It must be said the ECB sends out
contradicting signals here, as it boasted in one of its recent publications
that its “credit easing” had “significantly lowered yields in a broad set
of financial market segments”. Low and negative rates are also seen as part of
the ECB’s perceived overall dovish monetary policy, along with QE, which helped
to expand the ECB’s balance sheet, making it even less
credible for the ECB to claim it can’t really be blamed for any of it
all.

Even if one would be able to prove the ECB and
other central banks have been key in driving interest rates down, one could
argue – as they would – that these so-called “stabilisation benefits” may have
helped avert more damage to savers, pension funds and insurers. To which the
opponents then would retort that a long overdue correction, which would also
avoid moral hazard, may have been beneficial for the health of the system on
the long term.

One last important element in this discussion
is that since 2011, the real interest rate on German savings, distinct from the
nominal interest rate, has actually been rising. This is due to falling consumer prices, which
partially are the result of international factors, such as China’s
deleveraging. So when ordinary savers see their interest income disappearing,
they should actually be happy to have more purchasing power thanks to
statistics showing falling prices. In theory, these stats also take into account Germany’s increasing real estate prices.

Obviously, one could argue that their
purchasing power would have increased even more in the absence of low nominal
interest rates. Then again the deflationary pressure may have also hit their
salaries, at least in the short term, but from an Austrian economics viewpoint,
it’s a necessary – and painful – adjustment needed to kick-start growth again.
This all indicates that in a globalized economy, debates about purchasing power
and inflation aren’t easy to settle.

2)In the Eurozone, people save less for a rainy day

Another effect of the ECB’s low rates seems to
be that people save less for a rainy day. That’s true at least for people in
the Eurozone, as the global savings rate is up since 2009. Eurozone households saved 7.77% of disposable income in 2008,
which is now down to 5.71%. Net saving per inhabitant in the Eurozone has even
decreased by a whopping 50% during the last few years, from €2,400 at the end
of 2007 to only €1,200 in 2013.[1][1]

[1]

Obviously correlation may not be causation and
other factors, such as higher unemployment, also play a role here, while a
detailed country-by-country look reveals sharp differences. A big drop in the
percentage of households saving their disposable incomes can be witnessed in
Austria, Belgium, Italy, Greece, Slovenia and Ireland, while not much has
changed in Germany, France and Finland. In Estonia, the Netherlands and
Slovakia.

In any case, an economic crisis affects this:
it can drive the savings rate even lower, or sometimes even up: the Dutch real estate market went through a severe crisis, as up to one in
three house owners were in negative equity, and still the savings rate
increased. In Greece, which suffered its well-documented crisis, a modestly
negative savings quote of -3.84% in 2008, then broadly similar to the one in
the Netherlands, turned into a massively negative 17.28% in 2014.

Also government finances in the Eurozone may
be affected by the savings rate on the long term. Higher levels of household savings
are considered to allow a larger portion of a country’s overall debt to be
financed internally, which is seen as more sustainable and explains why for
example Japan has been able to rock up its debt to a whopping 229% of
GDP.

More fundamentally, long-term economic growth requires capital investment into infrastructure,
education and technology, as well as in factories, business expansion. A
typical domestic source for this are household savings.

3)Struggling governments and shaky banks benefit

It’s quite well-documented that shaky
governments and banks in the Eurozone are kept afloat due to the extraordinary
low or even negative interest rates. When the ECB started its “LTRO
–programme” in 2011, thereby issuing loans with cheap interest
rates to banks, French President Sarkozy openly boasted the real purpose was to
fund governments, when he said: “This means that
each state can turn to its banks, which will have liquidity at their
disposal.”

It should be noted
that LTRO may have supported the eurozone’s periphery even more than the
general low interest rate policy. This becausea large portion of
the financing provided to eurozone banks through the LTRO was used to buy
periphery sovereign debt, with eurozone periphery banks in Ireland, Italy,
Spain and Greece taking the majority of the first 36-month issue in late 2011.

Long term long interest rates, which, as
opposed to LTRO, may only be to a certain extent the consequence of the ECB or
even other leading central banks, did help governments in an indirect way. They
propped up shaky banks and their “bad debt”, so governments wouldn’t have to
bail them out. It was estimated by Spain’s IE Business School that in 2011, more than 90% of
mortgages in Spain were tied to short-term interest rates and an 0.75
percentage point rate increase would have added almost €1,000, or around
$1,430, per year to the average Spaniard's mortgage payment. Modest ECB
interest rate hikesin 2011 may have
been one of the triggers pushing the Spanish government to request a €100bn
bailout for its banks in 2012 after all. Whether this was the reason or not:
the ECBhasn’t
daredto increase rates
ever since.

As Bundesbank chief
Jens Weidmann pointed
out, the positive consequences low interest can constitute
for banks mainly exist on the short term, when he explained:"In the short
term, banks tend to profit from lower rates, as liabilities have shorter
maturities than their assets, meaning refinancing costs will fall before
interest rates do (...) But the longer the period of low interest rates
continues, the more this eats into interest rate
earnings."

The more recent
phenomenon of negative interest rates is somehow puzzling. Why would financial institutions be happy to pay for the privilege of lending to highly indebted
governments?
One factor explained this are theBasel accounting rules, which declare sovereign debt “risk-free”,
something which the “European Systemic Risk Board”, chaired by Mario Draghi,
wants to be changed.

Whether “ordinary” businesses and citizens
profit from cheaper borrowing, which may compensate for the damage to savings,
isn’t very clear. And even if they would, and for example enjoy higher house
prices, somehave
claimed a bubble may be around the corner.

As inflation has fallen faster than the ECB
has cut nominal rates, overall real interest rates have actually risen substantially in the
Eurozone over the past four years. Still, in specific segments, borrowing costs
seem to be down:

The cost of eurozone
corporate borrowing has steadilyfallenover recent years, as a growing pool of corporate
bonds emerges with negative yields. This isn’t only due to low rates but also due to ECB bond buying, which drove down yields
on sovereign debt, on its turn pushing many investors into the corporate bond
market. The eurozone’s periphery certainly also enjoys cheaper borrowing rates.
For “non-financial counterparties”, loans of up to 1 million euro with a
maturity of 1 to 5 years have even become cheaper in Spain than in Germany.

Mortgage borrowing rates differ
a lot across the Eurozone. Despite the fact that both in Ireland and Spain, banks are still coping with the aftermath of
epic real estate bubbles, partially caused by membership of the common currency and its
easy money, mortgage loans are nowhere more expensive than in Ireland
and they are among the cheapest in Spain. On the sidelines, there have been incidents of negative mortgage rates for consumer
borrowing in Denmark, Belgium and the Netherlands.

Will this create a new real
estate bubble? At least for Spain, a high correlation can be witnessed between lower interest rates
and the increase in the level of credit destined to the housing sector.Also in Germany, however, prominent economist
Hans-Werner Sinn has claimed there is a “real estate bubble”, arguing that
average urban property prices having risen by more than one-third since 2010 –
and by nearly half in large cities. Others have countered that the German real estate market was facing
a long overdue upward correction anyway.

Increasingly
low rates don’t favour investors into real estate in an equal manner. They
particularly help homeowners who already own a house and have negotiated a
floating interest rate. They work to the disadvantage of first time buyers or
renters, who see prices rise.

Low interest rates also seem to correlate with
an increase in the value of European stocks, at least until the middle of last year, when
a world-wide correction started. In certain Southern European countries, as for
example Italy, this happened despite very low growth and persisting high
unemployment, indicating the “bubble zone” may have been reached, but no hard
proof of this is possible.

Even
if increasing stock or house prices may benefit a number of citizens, they
don’t so in a consistent way. Only a small fraction of
households in the eurozone – between 5% and 12% – own bonds, publicly traded
shares or mutual funds, according to
the ECB.

It
won’t come as a surprise that it’s mainly the rich who invest in stocks:
according to the ECB, among households in the lowest quintile of the income
distribution, only 2.2% own publicly traded shares, in contrast to 24.4% in the
top quintile. Certainly ECB President Mario Draghi wouldn’t be surprised, given
how he admitted last year that the ECB’s aggressive monetary
easing may contribute to inequality, mentioning how “the distribution of
wealth” may be affected.

That
manipulating interest rates carries along the risk of creating investment
bubbles, is the main reason why savers should be wary to take Mr. Draghi’s advice that they “shouldn’t just invest their money
in savings accounts, given that there are other possibilities”. Perhaps
precisely because of the fact that Draghi’s “other possibilities” carry more
risk, it’s mainly those with more resources who have been exploiting them.

Conclusion:

The debate on the effects of low long term
interest rates is fraught with controversy about whether and to what extent
central banks even have the power to affect long term interest rates, whether
they should try to manipulate them and what the consequences are. The overview
above makes clear that the effects are in any case material and that the ECB
has some role in all of it, but it’s hard to determine how big.